Did you know? If you own a closely held corporation, you have the option to borrow funds from your business at rates lower than those typically offered by a bank. However, it's crucial to mitigate potential risks and ensure that an adequate interest rate is charged.
Interest rates have risen in recent years, prompting shareholders to consider taking loans from their corporations instead of paying the higher rates offered by banks. Generally, the IRS expects closely held corporations to charge interest on related-party loans, such as loans to shareholders, at rates that meet or exceed the applicable federal rates (AFRs). Failure to do so could result in adverse tax consequences. Fortunately, AFRs are typically lower than those charged by commercial lenders.
So, borrowing money from your closely held corporation to cover personal expenses, such as your child's college tuition, home improvements, a new car, or paying off high-interest credit card debt, can be beneficial. However, it's important to avoid key risks.
1. Create a Legitimate Loan
When borrowing money from your corporation, it’s essential to establish a bona fide borrower-lender relationship. Failing to do so could lead the IRS to reclassify the loan proceeds as additional compensation. This reclassification could result in an income tax bill for you, as well as payroll taxes for both you and your corporation. However, your business would be allowed to deduct the amount treated as compensation and the corporation’s share of the related payroll taxes.
Alternatively, if your company is a C Corporation, the IRS might argue that you received a taxable dividend, which would trigger taxable income for you without any offsetting deduction for your business.
To avoid these issues, it's crucial to draft a formal written loan agreement that clearly establishes your unconditional promise to repay the corporation a fixed amount, either under an installment repayment schedule or on demand by the corporation. Also, document the terms of the loan in your corporate minutes and take other steps to reinforce the legitimacy of the loan.
2. Charge Adequate Interest
To avoid triggering the complicated and generally unfavorable "below-market loan rules," your business should charge a minimum interest rate that meets or exceeds the IRS-approved Applicable Federal Rate (AFR). An exception to these rules applies if the total loans from a corporation to a shareholder are $10,000 or less. These AFRs are calculated assuming monthly compounding of interest.
Current AFRs:
The IRS publishes AFRs monthly based on market conditions. For loans made in July 2024, the AFRs are:
4.95% for short-term loans of up to three years
4.40% for mid-term loans of more than three years but not more than nine years
4.52% for long-term loans of over nine years
The AFR that applies to a loan depends on whether it’s a demand loan or a term loan—a distinction that carries significant importance. A demand loan is one that must be repaid in full at any time upon notice and demand by the corporation. In contrast, a term loan is any borrowing arrangement that doesn’t qualify as a demand loan. For a term loan, the AFR depends on the loan's duration, and the same rate applies throughout the loan term.
Here's an example.
Let's say you borrow $100,000 from your corporation, with the principal to be repaid in installments over 10 years. Since this is a term loan with a duration exceeding nine years, the AFR for July would be 4.52%, compounded monthly, for the entire 10-year period. The corporation must then report the loan interest as taxable income.
Alternatively, if the loan document grants your corporation the right to demand full repayment at any time, it qualifies as a demand loan. In this case, the AFR is determined by a blended average of monthly short-term AFRs for the year. If interest rates rise, you'll need to pay more interest to comply with the below-market loan rules. Conversely, if rates fall, you'll benefit from paying a lower interest rate.
From a tax perspective, term loans exceeding nine years are generally more advantageous than short-term or demand loans because they lock in the current AFRs. If interest rates decline, you can repay a high-rate term loan early and have your corporation issue a new loan at the lower rate.
Shareholder loans can be complex, particularly if the loan carries an interest rate below the AFR, if the shareholder stops making payments, or if the corporation has multiple shareholders. To navigate these challenges and ensure compliance with tax regulations, it's advisable to contact us for guidance tailored to your specific situation.